FHA Financing: Is it right for you?

Posted by Jason Kauffman on September 13, 2022

FHA mortgages are one of the most flexible loan options for borrowers. The qualifying guidelines allow for credit scores below a 620 which is a barrier to many people seeking to qualify for Conventional loans. Many borrowers think that FHA financing is only for first time homebuyers but it is actually not. This article will help you understand more about FHA financing and why it might be the right loan program for your situation.

A Little History

The Federal Housing Administration (FHA) was created by congress in 1934 as a response to conditions at the time that were prohibitive to home ownership. Eventually the FHA was folded into the Department of Housing and Urban Development’s (HUD) Office of Housing in 1965.

It’s important to point out that the FHA doesn’t fund mortgages. They insure FHA loans for the lenders that make the loans. This insurance protects the lender from losses in the event they have to take action through foreclosure proceedings due to the homeowner defaulting on their loan. This was the protective measure implemented by the FHA that made it possible for lenders to be more comfortable making loans with lower down payments. Ultimately, the goal of the FHA home loan program is to increase access to credit for home ownership in America.

How do FHA loans work?

FHA loans look like many other types of mortgages you might see out there. Many people misstate that FHA homebuyers choose FHA because they cannot get Conventional financing, and that is often not the case. FHA does require that the home you are purchasing be a primary residence. The only exception is in the case where you are buying a multi-unit property (2-4 units) where you can live in one of the units and qualify with rental income from the other units.

Down Payment Requirements

FHA mortgages require a 3.5% down payment. There is flexibility in where you get this down payment. These typical sources are acceptable:

  • Checking / Savings
  • Stocks
  • Retirement Assets

Cash on hand is allowed with certain caveats, so speak with your mortgage professional about how best to document cash as a source for down payment.

Gifts are a very common source for down payment purposes and are allowed with certain rules about who it can be from:

  • Borrower’s relative or family member
  • Borrower’s employer or labor union
  • A close friend with a clearly defined interest in the borrower
  • A charitable organization
  • A governmental agency or public entity that has a program providing homeownership assistance to:
    • Low or moderate income families; or
    • First-time homebuyers

The last bullet point above is part of the reason so many first-time homebuyers utilize FHA financing in conjunction with down payment assistance programs. Its important to point out that there are situations where first-time buyers will utilize conventional financing with down payment assistance programs as well.

Loan Terms

FHA allows for loan terms of 15 years up to 30 years with a fixed rate. They also allow for Adjustable Rate Mortgages (ARMS) although these have been less common in recent years. More often than not, your mortgage professional will quote a 30 year fixed rate loan, but it is always wise to confirm the terms of any mortgage you are inquiring about.

Monthly Mortgage Insurance

FHA Loans have monthly mortgage insurance just like most Conventional loans with less than 20% down have mortgage insurance. The difference is that Conventional loans have mortgage insurance that is provided by private mortgage insurance companies who set their mortgage insurance rates. The FHA sets the mortgage insurance rate on all the loans they insure. In truth, the FHA mortgage insurance is calculated on the average annual balance of your loan, and is recalculated each year. So FHA mortgage insurance decreases slowly over time.

Private mortgage insurance companies tier their mortgage insurance rates based on different risk factors, but the most common one is credit score. FHA has a fixed mortgage insurance rate that can change based on down payment amount and loan term, but not based on credit score. This is what makes FHA financing more attractive than Conventional financing for buyers with a low down payment and credit scores at or under a 700 (in many cases).

Its not to say that those borrowers under a 700 credit score can’t get a Conventional loan, but they may wind up paying a much higher mortgage insurance rate than they would if they go with an FHA loan instead.

Another caveat to FHA monthly mortgage insurance is that in most cases it will be on the loan for the life of the loan and in a handful of cases it will drop off after 11 years. This is another consideration when you are comparing a low down payment Conventional loan to an FHA loan option.

Upfront Mortgage Insurance Premium

All FHA loans have a 1.75% mortgage insurance premium (called upfront MIP) that is charged at closing. This amount can either be financed or paid in full. There are a few specific case where this premium would be reduced, but they all related to refinancing older FHA loans.

This upfront premium goes into a pool with all the other FHA premiums and further strengthens the FHA’s balance sheet in the event insurance claims have to be paid due to foreclosures.

Qualifying for an FHA loan

When compared to other loan types, FHA loans have a very flexible guideline structure. This allows lenders to qualify individuals that might not be able to get a loan through another program due to certain characteristics about their loan file.

Credit Report

As with any mortgage application, your lender is going to have pull a credit report. Technically FHA mortgages don’t have a minimum credit score requirement, although many lenders have overlays that create minimum credit score thresholds. FHA also doesn’t require that you necessarily have a credit score at all, with the caveat that you build a non-traditional credit history with other accounts.

If there are recent late payments on accounts, non-medical collection accounts, bankruptcy, foreclosure, etc. you will be required to provide an explanation in most cases. FHA has well defined rules around how long you have to wait following a foreclosure or bankruptcy. Anytime you are dealing with these types of issues in your credit history it’s advisable to reach out to a mortgage professional and have them help you navigate the guidelines.

Debt to Income Ratio

This is the total of all your monthly debts and the new housing payment, divided by your gross income. FHA’s stated rules for manual underwriting are that you cannot go above 43%, although depending on your credit profile we’ve seen this pushed as high as 56.9% through the automated underwriting system (AUS).

FHA financing has been around for over 80 years and will likely continue to serve its goal of expanding homeownership to Americans. The guidelines for FHA are somewhat complex and its important to align yourself with a mortgage professional that understands them. FHA may or may not be the best option for your situation, but it’s important to understand the advantages so that you can make the right choice when you’re purchasing your next home.

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